The lack of agreement in the different markets is misleading investors. The economic climate is uncertain. On the one hand, the rise in rates to keep inflation at bay should cool the economy –as has always happened throughout history–, although its magnitude is unknown. In principle, if there is no historical exception, this will come. But, on the other, there is the price of the stock market and of the bonds, which point to very different paths.
The S&P 500, Wall Street’s benchmark index, has risen more than 7% so far this year, and has taken off about 15% from the October 2022 lows of 3,577 points. Levels that make many experts consider that the worst could be over and that for others, including the majority of investment banks, the recession would not be a price.
Instead, the bond market is sending other signals. After getting the yield curve inversion between US 10-year and 2-year bonds to its deepest level since the 1980s – usually an indicator of a clear economic recession – now US Treasury bills at a month have exceeded the level of 5.5% profitability. This is a percentage that has not been transferred since the financial crisis of 2008.
The signals from the markets are completely contradictory. Marko Kolanovic, JP Morgan’s chief equity strategist, believes that the current situation is one to view with a great deal of caution. “Normal correlations are less consistent now than in other situations in the past,” he says.
“In general, we continue to see long-term leading economic signals that point to tough times as the market makes more optimistic assumptions. A rally based on a handful of stocks can easily be reversed,” says the strategist. That is why the entity is inclined to take legitimate signals such as “the inversion of the rate curve and the credit situation” as “unreliable” signals to consider that a “bull market” can be opened today.
Kolanovic exposes that the rebound in the stock market from the lows, precisely, has led by the hand of a handful of values and that it can be easily reversed. “While the ChatGPT euphoria may have substance, the question is whether it is enough to underpin a broader market rally… As it stands, the difference between capitalization-weighted and equal-weighted quarterly returns highlights this extreme distortion”, assures the expert.
Furthermore, he explains that ideally, in a rally, one would like to see rising participation, and cyclical signals confirming, eg small cap vs. large cap, copper vs. gold, etc. Instead, we would be looking at the exact opposite: the tighter rally with cyclical signals going in the opposite direction.
“As already mentioned, the nature of the stock market rally presupposes a soft landing, that is, that the downward rates estimated by the market will not return to a ‘goldilocks’ or Goldilocks scenario (stable growth, low inflation and moderate interest rates). However, the history of bull cycles does not offer much hope in this regard, since only two of them in the modern era produce a soft landing with some travel before the recession: in the mid-late 1980s and in 1994. “, Explain.
Meanwhile, we haven’t had application numbers heading into the “danger zone” above 250,000 until now, so despite a decent jobs number, the cracks are beginning to emerge. “That’s why we see value in staying underweight US stocks also in light of the risks around the US debt ceiling,” he notes.
“A good starting point for analyzing the markets is to look at the indicated probability of recession, which is calculated by comparing the typical drop in a recession to the current drop, and in this case, Wall Street and EMU stocks are trading 34%. and an 11% probability of recession, while equity volatility is consistent with a 3% probability,” he says.
In the report, JP Morgan’s chief strategist comments that another way of looking at the valuation disconnect is to plot equity returns against some “soft data” and liquidity/monetary signals. “This shows that stocks are overvalued and have completely ignored other leading indicators, so these are all valid motivations in our view to stay in US and Eurozone equities and add longer-term hedges on variable income ”, he deepens.
This would be especially true at a time when the momentum behind the recent rally in equities may be fading and the issue of the US debt ceiling could become an additional headwind for risky assets, given the experience of the 2011.
“While we recognize that, at the time, the strong selling of risk assets due to the issue of the US debt ceiling of August 2011 was amplified by the euro debt crisis, it would be difficult to avoid at least a modest sale of risky assets if this question goes all the way as in August 2011”, he concludes.